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Understanding Loan Covenants

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There's more to a bank loan than the interest rate. If you're securing a loan for your business, be sure to consider carefully the covenants in the loan agreement. Put in place to safeguard the bank, loan covenants can stipulate everything from financial ratios that the borrowing company must maintain to salary caps for its executives. What's more, any violation of an agreed-upon covenant can signal to your banker that something might be awry at your company, and you run the risk of having the loan called in.

Understanding loan covenants before you sign on the dotted line can help you better comply or, perhaps, prepare to negotiate more realistic covenants. The following five steps should help you navigate the loan-covenant jungle and put you in a better borrowing position:

Inquire about the bank's expertise in -- andfunding experience with -- your industry.Covenants from industry specialists areoften more realistic.

Ask to see a sample list of covenantsbefore the date of the closing, so youcan avoid a situation in which desperationfor funds -- or a lack of carefulanalysis -- persuades you to simply signanything. Make certain that you can livewith the bank's terms about theconsequences of going out of compliance.

Do a computer run of your company's pastperformance during the most recent one-,two-, and three-year periods to see if youcould have complied with all loancovenants, especially key ratios, if yourloan had been in place before now.

If those results indicate future problems,schedule a visit with your banker andsuggest more realistic covenants.